Sunday, October 9, 2016

When Genius Failed (Chapter 3)

John Meriwether was finishing up
his fund-raising for LTCM in 1994.In
February of that year, Greenspan raised short-term interest rates for the first
time in five years and in response, bond prices decreased in response to the
rise in interest rates.European bonds
began crashing.Michael Steinhardt had
bet on European bonds and saw himself losing about $7 million with every
hundredth of a percentage point and would lose as much as $800 million in only
four days.Meriwether took advantage of
the investors panicking to sell and in May of that year, Long-term rose 7
percent which resulted in profits.They
noticed that markets were linked and that a trend in a certain market could
spread over to the next and so on.

Meriwether and LTCM then turned
their attention to certain 30-year bonds.There were two kinds, ones that had been issued 6 months prior and ones
that were just issued.The ones that
were issued 6 months ago were known as off the run and were less desirable due
to being less liquid than the ones that were just issued, known as on the run
bonds.The on the run bonds were
actually yielding 12 basis points less than the off the run bonds.LTCM purchased $1 billion of the off the run
bonds, seemingly risking all of their capital right away.LTCM used certain leverage powers they had
when interacting with other financial institutions.They refused to pay what was called a haircut
when borrowing money (a fee banks charged borrowers to protect themselves from
bond prices rising), would convince banks to loan to them for a longer period
of time that usual.In the end, LTCM
made $15 off of their off the run bond purchase deal.That was but one of many trades that LTCM
turned to gold in 1994, they couldn’t miss.

LTCM also participated in the
trading of IO’s in 1993, when 2/5 American citizens refinanced their
homes.They bought a lot of these IOs
and eventually made several hundred million dollars from them.They also participated in trades in Europe
and third world markets.

Question:

What is a “snap trade”?How would such a trade benefit LTCM and what made it so appealing to
them?

3 comments:

A snap trade was when Long Term would buy off the run treasury bonds while at the same time selling on the run treasury bonds and anticipating that the spread between the two bonds would come back together and they would make the spread difference. This was appealing to LTCM because they had the purchasing power to make such a large amount of these trades and reap huge earnings do to the size of their investment. They figured that the spreads would eventually have to come together. However the nature of their investment was it's illiquidity and when the market crashed and everyone wanted to sell, LTCM was left with assets with widening spreads and huge losses.

As mentioned earlier the snap trade is Long Term looking to earn a profit on the spread of treasury bonds. This technique was very profitable in certain variables to hold true. However, when the market crashed, Long Term was holding assets that were losing money by the day. The idea of the snap trade though was one I had never seen or heard. I didn't realize that a firm or company had so much purchasing power to influence markets in their preference to create a profit. To me, this seems illegal, and that government would have intervened. But, strategies like snap trades shows that when you have significant purchasing power requires a large amount of skin in the game. Thus, when the market crashes, you can be burned by badly in losses.

Snap trades were used by Long Term Capital Management to capitalize on the converging spread between on the run and off the run treasury bonds.

It was appealing to LTCM because they would have most of the purchasing power to pretty much rig the trades into their favor. This allowed them to create massive amounts of profit. Unfortunately, when the market crashed, LTCM was stuck with assets losing huge amounts of value.